The average investor's idea of how to diversify can be summed up as not putting all your eggs into one basket.
In its original form, diversifying your portfolio revolved around reducing exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate.
Since these are completely different kinds of investments, then they are unlikely to move in the same direction at the same time.
The idea is that losses from a temporary decline in one area will be offset by continuing gains in the other two.
It wasn't long before someone decided that if diversification worked using a mixture of stocks, bonds, and other investments, then it would also work for a portfolio of stocks alone.
Academics supported the theory and stock brokers (who, at that time, were rewarded for bringing in large accounts for the brokerage houses) immediately seized on the idea as a way to bring the aura of science to selling a variety of stocks to their rich clients.
It didn't take long before the average person accepted the notion, and believed in the value of diversification in the same way they believed in the magnetism.
Everyone knew that magnetic force attracted iron, even though they didn't know what actually caused magnetism or its relationship to electrical charge, and so on.
The average person's lack of knowledge about the details of magnetism generally didn't cause them any problems.
Unfortunately, their lack of knowledge about the details of how to diversify often cost them a bundle.
Correlation In the context of the stock market, the generally accepted view of diversifying your portfolio spreading your money around instead of putting it all into one investment has a problem.
The trouble is that simply spreading your investments out among a variety of stocks or funds may or may not provide you with a useful degree of diversification.
Consider the following companies: the Zhejiang Wangzhuo Knitting Company in China, Marriott Catering in the United States, and Shimadzu Manufacturing of Japan.
One might think that investing in three companies in different businesses and in different countries would provide a fairly good level if diversification.
However, all three of these companies generate significant portions of their total revenues from the airline industry.
Zhejiang Wangzhuo makes airline blankets.
Marriott Catering supplied in-flight meals.
Shimadzu makes airplane parts.
A sudden drop in airline travel, such as might be caused by a significant increase in jet fuel prices, would hurt the bottom line in all three of these companies and, in turn, hurt their stock prices.
As you can see from this example, companies can turn out to be correlated as a result of subtle causes.
Performing an effective study to figure out the correlations between two companies is a not a simple task.
It may be almost as involved as putting together the data for fundamental analysis of the two stocks.
One needs to examine the companies products, suppliers, customers, and locations (to determine applicable government regulations, shipping issues, and primary currencies), as well as other possible factors.
Another approach to gauging correlation is direct comparison of their stock price movements.
One can mathematically measure whether the prices of their financial instruments move in similar ways or not.
The advantage of this approach is that it may identify correlations that a study of the two companies may not reveal.
The disadvantage is that time-series correlation is not a simple calculation to perform.
One easy solution to the calculation problem is to go to the internet.
For example, 12-month and 6-month correlation numbers for a wide range of stocks and ETFs can be found at the free website that will help you learn how to diversify effectively.
One of the hidden challenges in accurately calculating correlation is that it changes over time.
It is not constant.
Correlation increases when it is least convenient -- during bear markets.
When everything is going down, correlation often increases rapidly within a given market.
At least with the original notion of diversification (stocks, bonds, and real estate) there was a fair chance that a decline in one would not effect the others at the same time.
But diversification will not provide much protection if the entire stock market is going down.
In that situation, the investor must be ready to employ stronger methods to protecting their principal.
Other Difficulties Some people reason that if a little diversification is good, then a lot is better.
But if you think about it, diversification not only protects you from big losses (by reducing the impact of declines in individual stocks), it also protects you from big gains (by reducing the impact of advances in individual stocks).
This is not to say that diversification is bad.
Putting too large a portion of your money into any investment is a recipe for disaster.
But putting your money into too many investments has its drawbacks, too.
As your risk approaches zero, so can your profits.
Some acknowledged experts don't go along with the academic view that diversification is of paramount importance.
They use it but it is not their first concern when considering an investment.
Warren Buffett -- whose qualifications speak for themselves -- said, "We diversify substantially less than most investment operations.
We might invest up to 40% of our net worth in a single security...
" Speaking about the difficulty in finding meaningful correlation information, economist John Maynard Keynes said it makes more sense to have a big stake in a company you know about rather than having small positions in a large number of companies you know nothing about.
Conclusion Academics insist that dire things will befall us if we don't stay properly diversified.
Market professionals acknowledge that knowing how to diversify is important, but most say that diversification is more useful as a servant than it is as a master.
The general consensus among people who are actually managing money is that diversification as something to keep in mind, but it is secondary to truly critical issues like exit discipline and position sizing.
Copyright -- Richard Ahrens 2010
In its original form, diversifying your portfolio revolved around reducing exposure to risk by combining a variety of investments, such as stocks, bonds, and real estate.
Since these are completely different kinds of investments, then they are unlikely to move in the same direction at the same time.
The idea is that losses from a temporary decline in one area will be offset by continuing gains in the other two.
It wasn't long before someone decided that if diversification worked using a mixture of stocks, bonds, and other investments, then it would also work for a portfolio of stocks alone.
Academics supported the theory and stock brokers (who, at that time, were rewarded for bringing in large accounts for the brokerage houses) immediately seized on the idea as a way to bring the aura of science to selling a variety of stocks to their rich clients.
It didn't take long before the average person accepted the notion, and believed in the value of diversification in the same way they believed in the magnetism.
Everyone knew that magnetic force attracted iron, even though they didn't know what actually caused magnetism or its relationship to electrical charge, and so on.
The average person's lack of knowledge about the details of magnetism generally didn't cause them any problems.
Unfortunately, their lack of knowledge about the details of how to diversify often cost them a bundle.
Correlation In the context of the stock market, the generally accepted view of diversifying your portfolio spreading your money around instead of putting it all into one investment has a problem.
The trouble is that simply spreading your investments out among a variety of stocks or funds may or may not provide you with a useful degree of diversification.
Consider the following companies: the Zhejiang Wangzhuo Knitting Company in China, Marriott Catering in the United States, and Shimadzu Manufacturing of Japan.
One might think that investing in three companies in different businesses and in different countries would provide a fairly good level if diversification.
However, all three of these companies generate significant portions of their total revenues from the airline industry.
Zhejiang Wangzhuo makes airline blankets.
Marriott Catering supplied in-flight meals.
Shimadzu makes airplane parts.
A sudden drop in airline travel, such as might be caused by a significant increase in jet fuel prices, would hurt the bottom line in all three of these companies and, in turn, hurt their stock prices.
As you can see from this example, companies can turn out to be correlated as a result of subtle causes.
Performing an effective study to figure out the correlations between two companies is a not a simple task.
It may be almost as involved as putting together the data for fundamental analysis of the two stocks.
One needs to examine the companies products, suppliers, customers, and locations (to determine applicable government regulations, shipping issues, and primary currencies), as well as other possible factors.
Another approach to gauging correlation is direct comparison of their stock price movements.
One can mathematically measure whether the prices of their financial instruments move in similar ways or not.
The advantage of this approach is that it may identify correlations that a study of the two companies may not reveal.
The disadvantage is that time-series correlation is not a simple calculation to perform.
One easy solution to the calculation problem is to go to the internet.
For example, 12-month and 6-month correlation numbers for a wide range of stocks and ETFs can be found at the free website that will help you learn how to diversify effectively.
One of the hidden challenges in accurately calculating correlation is that it changes over time.
It is not constant.
Correlation increases when it is least convenient -- during bear markets.
When everything is going down, correlation often increases rapidly within a given market.
At least with the original notion of diversification (stocks, bonds, and real estate) there was a fair chance that a decline in one would not effect the others at the same time.
But diversification will not provide much protection if the entire stock market is going down.
In that situation, the investor must be ready to employ stronger methods to protecting their principal.
Other Difficulties Some people reason that if a little diversification is good, then a lot is better.
But if you think about it, diversification not only protects you from big losses (by reducing the impact of declines in individual stocks), it also protects you from big gains (by reducing the impact of advances in individual stocks).
This is not to say that diversification is bad.
Putting too large a portion of your money into any investment is a recipe for disaster.
But putting your money into too many investments has its drawbacks, too.
As your risk approaches zero, so can your profits.
Some acknowledged experts don't go along with the academic view that diversification is of paramount importance.
They use it but it is not their first concern when considering an investment.
Warren Buffett -- whose qualifications speak for themselves -- said, "We diversify substantially less than most investment operations.
We might invest up to 40% of our net worth in a single security...
" Speaking about the difficulty in finding meaningful correlation information, economist John Maynard Keynes said it makes more sense to have a big stake in a company you know about rather than having small positions in a large number of companies you know nothing about.
Conclusion Academics insist that dire things will befall us if we don't stay properly diversified.
Market professionals acknowledge that knowing how to diversify is important, but most say that diversification is more useful as a servant than it is as a master.
The general consensus among people who are actually managing money is that diversification as something to keep in mind, but it is secondary to truly critical issues like exit discipline and position sizing.
Copyright -- Richard Ahrens 2010